Credit insurance is a risk mitigation tool that protects companies from customer default on credit obligations due to commercial and/or political reasons. Commercial perils that are covered by credit insurance include customer insolvency and protracted default, i.e., slow-pay. Political risks covered include war, riot, insurrection, currency inconvertibility and, generally, any foreign government act that would prevent the importer from paying an accounts receivable obligation.

While commonly used for decades in most of Europe and much of Asia, United States creditors have been slower to accept the strategic value of this type of insurance coverage.

Why use Trade Credit Insurance?

There are three primary reasons for purchasing trade credit insurance: sales concerns, financing concerns, and risk mitigation.

Sales Concerns

Trade credit insurance allows companies to be more comfortable with, and aggressive in, extending open account repayment terms, both to expand into new international markets and to protect existing market share in foreign and domestic markets. Enhancing the customer’s cash flow by providing them longer to pay, allows them to purchase more product and strengthens the buyer-seller relationship.

Financing Concerns

Trade credit insurance facilities or enhances various types of accounts receivable financing programs, including securitizations, receivables discounting, and FASB-compliant receivables purchase programs.

Asset-based Financing. Banks will generally lend against foreign receivables if the obligations are insured, and insurance on domestic receivables allows banks to increase the advance rate on existing asset-based credit facilities. Depending upon the seller’s industry and customer portfolio, insurance can sometimes help financial institutions justify reduced costs on existing facilities, which in turn can help pay for the insurance itself. The balance sheet is further improved with insurance, since bad debt reserves can be drawn down once previously uninsured exposures are insured at 90% to 100% indemnity.
Balance Sheet Management. By selling insured receivables to a bank and removing them from the balance sheet, companies can improve their return on assets and reduce days sales outstanding (DSO).
Customer Financing. Customers are increasingly requesting extended repayment terms. Credit insurance can support up to 180-day repayment terms for non-capital goods, and up to seven years for capital goods. Packaging and passing the cost of goods, freight, insurance and your bank financing to your customer allows you to extend prime rate or libor-based loans to them at no cost to you with very limited recourse.

Risk Mitigation

For many firms, the accounts receivable balance is the largest uninsured asset on the balance sheet. At the same time, many companies believe that loss experience is a reasonable justification for not insuring these assets, despite the negative impacts that an unforeseen, sizeable loss could have on the company.

Domestic Risk. 2001-03 carried a record number of insolvency filings in the U.S., and past trends indicate that the years immediately following a recession actually carry more bankruptcy activity than the period of recession itself. A key consideration is that the cost of credit insurance is less than the cost of replacing the loss with new sales. Insurers will generally provide domestic cover on either a whole-portfolio, or top-buyer basis.
Export Risk. Foreign buyers are geographically and culturally distant from the seller, making extending credit and collecting foreign accounts more difficult. History has shown that war, civil strife, confiscation of the importer’s business, or currency devaluation, restriction and inconvertibility can occur almost out of nowhere. We need only look at developments in Argentina, Ecuador, Brazil and Venezuela over the last few years, the 1998 Asian economic crisis, and the devaluation of the Mexican peso in 1994 to remind us of this. As well, bankruptcies are on the rise worldwide, even in countries perceived as “safe”, like Australia, Japan, Canada and countries in Western Europe. Insurers can provide export protection on global portfolios and, in some cases, on specific regions (such as Latin America or Asia).

Types of Trade Credit Insurance Policies

Whether credit insurance is being used to increase sales and market share, to facilitate or enhance financing, or to mitigate risk, there are primarily two coverage structures available to sellers: single-buyer insurance and multi-buyer insurance. However, specialized coverage structures can be crafted to suit a specific transaction or business structure. And, for exceptional large or risky exposures, a consortium of insurance companies can be brought together to underwrite one policy.

Single-Buyer Credit Insurance

A single-buyer policy is written to cover one particular transaction or shipments made (or services rendered) to one customer over a 12-month period. Single-buyer insurance can be divided into three sub-categories, depending upon the repayment terms you need to offer your customer:

Short-term. Covers repayment terms of one year or less.
Medium-term. Covers repayment terms greater than one year and up to five years.
Long-term. Coverage is usually capped at seven year repayment terms, although there may be insurers willing to cover longer-term obligations under a specialized policy.

Note: Medium-term and long-term single-buyer insurance is typically not an option for the sale of non-capital goods.

There are a limited number of insurers that provide single-buyer credit insurance, and because the risk is concentrated to one buyer in one country, it is necessary to provide the insurance underwriters with a well-developed submission. Exceptions are made for buyers already known to the insurers or those that are publicly traded, but in all other cases it is the responsibility of the applicant to provide a credit agency report on the customer and financial statements for the last three fiscal periods. A bank reference, trade references, and interim financial statements may also be required.

It is also critical that the underwriter fully understand your business, your customer’s business, and the transaction to be insured so that the insurance policy can be properly structured.

Multi-Buyer Credit Insurance

The multi-buyer policy is written to cover a portfolio of exposures. It traditionally covers only short-term payment obligations (up to one year open account for capital goods and up to 180 days open account for non-capital goods). However, there are now some insurance companies that can support up to two or three-year repayment terms given to end-users for capital equipment under their multi-buyer policies. Some insurers have also been willing to support up to two-year terms to support dealer floor plan programs.

Multi-buyer policies can be divided into three sub-categories:

Domestic Credit Insurance. Covers sales to buyers located in the same country as the insured. For U.S. companies utilizing domestic credit insurance, insurers will often allow the inclusion of Canadian customers within the same policy as the risks of selling to Canada are often perceived to be the same as selling within the United States.
Foreign Credit Insurance. Covers sales to buyers located in countries other than that of the insured company.
Domestic and Foreign Insurance Combined. Covers credit sales to both domestic and cross-border customers.

Multi-buyer insurance underwriters typically require companies to insure all of their open receivables under the policy. They do not normally allow the insured to pick and choose customers (or, with foreign credit insurance, to pick and choose countries) that will or will not be included in the policy.

The philosophy behind the whole-turnover, non-adversely selected spread of risk is that the insurance company will cover both higher risk and less risky customers in order to provide a blended premium rate structure that applies to all customers. Exceptions to the whole-turnover requirement for multi-buyer insurance are sometimes available, as a specific insurer may be willing to write the coverage as long as the covered portfolio presents a reasonable spread of risk.

A company using multi-buyer credit insurance must quality each of their customers for coverage. In most cases, the insured will have a discretionary credit limit, which will allow them to extend an insured line of credit (up to a specific dollar amount) at their own discretion. The other means of qualifying a customer for an insured line of credit is to submit an application for a credit limit to the insurance company.

Underwriting Philosophies

Among multi-buyer credit insurers, there exist two primary underwriting philosophies: 1) Ground-Up Underwriting; and 2) Excess of Loss Underwriting.

Ground-Up Underwriting

Ground-up coverage is traditionally written with no (or a low) deductible and no (or a low amount of) discretionary authority. Hence, the insurance company underwrites each buyer in the insured’s portfolio from the “ground up”. To establish a customer credit limit, the insured typically provides the name and address of each customer. The insurance company researches them independently, assessing their creditworthiness, and rendering a credit limit decision. In cases where the insurance company cannot obtain adequate information on a particular buyer, the insured will be expected to provide information like financial statements.

If requested to do so, ground-up insurers can offer a Discretionary Credit Limit (DCL). A DCL allows the insured to extend credit to a buyer up to a predetermined maximum amount without obtaining the formal approval of the insurance company. In many cases, the ground-up insurer will require an annual aggregate policy deductible (not a per loss deductible) in an amount equal to the DCL. The insurer may also have a separate aggregate limit of liability for buyers qualified under the DCL.

All types of companies, large and small, utilize ground-up insurance. Companies with less developed credit departments or those lacking experience in foreign credit may fit well within this type of underwriting philosophy, as the insurance company essentially enhances the company’s credit evaluation process. Firms with well-developed credit management policies may also prefer ground-up underwriting in new or fast-growing markets as it allows them to outsource a portion of the credit evaluation function, giving them more time to monitor A/R and focus on collection.

Excess of Loss Underwriting

In this type of underwriting scenario, coverage is structured with an annual aggregate policy deductible and a meaningful level of discretionary authority, allowing the insured to retain much of its own credit authority. Excess of loss insurers typically offer DCLs that are two to four times higher than the policy deductible. The level of discretionary authority offered by the insurer will typically be high enough to cover 75% to 80% of the insured’s portfolio. Only buyers requiring very large credit limits (or located in difficult markets where the DCL cannot be utilized) are specifically underwritten by the insurance company. For these buyers, the insured is required to provide supporting documentation to the insurance company (typically credit reports, trade references, and, for limits in excess of USD 100,000, financial statements).

Excess of loss underwriting is attractive to all types of companies. As the credit evaluation procedures utilized by the credit insurer are similar to those found in most corporate credit departments, companies that are less experienced in credit evaluationfind that this structure helps them to better develop their credit department and/or galvanize credit procedures across subsidiaries.

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The information in this article was provided by International Risk Consultants (www.irc-group.com), a specialist firm dealing exclusively in the areas of credit insurance, political risk insurance, and trade finance solutions. IRC North America has been headquartered in Columbus, Ohio since its founding in 1987, and has regional U.S. offices in Chicago, Houston, Indianapolis, Miami, New York City, San Francisco, and Portland, as well as overseas offices in Brazil, Hong Kong, China and Mexico. In 2003, IRC accepted an invitation to become the sole representative for the U.S., China, Brazil, and Mexico in the International Credit Brokers Alliance (www.icba-online.com). Today, IRC is able to offer globally integrated brokerage services to customers worldwide from their own offices and those of their allies in forty-five cities in twenty-five countries.

With local access to all major credit insurance markets, IRC and its partners are uniquely qualified to analyze global risks and structure solutions for companies seeking growth in a very competitive marketplace. In any language, culture or time zone, IRC is ready to work with the best companies in the world to help them meet competitive threats, overcome market resistance, work through financial complications, address fast-changing needs, and fulfill their growing ambitions. As experience, expertise, and energy are the cornerstones of our effort, we have successfully distinguished our company and our worldwide partners as the leading providers of client services in the industry.